I’m a Professor of Economics at University College, Dublin. I have a PhD in economics from MIT. I worked for the Federal Reserve Board from 1996 to 2002, regularly briefing Alan Greenspan and working on the FOMC's macroeconomic forecast. From 2002 to 2007, I worked for the Central Bank Ireland and attended many meetings at the European Central Bank.
My research on macroeconomic issues has been published in many of the world's leading economics journals. These days, in addition to my research, I teach classes, supervise PhD students and comment on macroeconomic and banking issues with a particular focus on Europe. I’m also a member of the European Parliament Economic and Monetary Affairs Committee’s expert panel of advisers on monetary policy. You can find out more about me at www.karlwhelan.com and follow me on Twitter at @WhelanKarl.

How Much Would Ireland Benefit from Replacing the Promissory Notes with a Long-Term Bond?

Since June’s Eurosummit, there have been many discussions about what kind of deal might follow from the summit’s commitment to re-examine Ireland’s debt burden. Ireland has committed €64 billion towards its banks, with about €35 billion of this going towards Anglo Irish Bank and Irish Nationwide which have now merged to form the dead-bank-walking Irish Bank Resolution Corporation (IBRC).

Dublin Docklands - This Was Supposed To Be The New Headquarters For Anglo Irish Bank (Photo credit: infomatique)

It is now seems clear that Europe’s politicians have decided that the IBRC-related component of Ireland’s bank debt is an issue that will have to be resolved between the Irish government and the ECB. (See news stories here and here.) In terms of the shape this resolution make take, reports have emerged that Irish finance minister, Michael Noonan, would like to replace the promissory notes provided to Anglo’s successor, the IBRC, with a 40-year bond.

Many people I’ve discussed this with are mystified by this idea. Isn’t this just replacing one kind of debt with another? And won’t paying off the debt over a longer-term just increase the total cost to the Irish people?

These are good questions and are worth taking seriously.

In relation to the first question, why not simply scrap the promissory notes? Well the purpose of the promissory notes is for IBRC to pay back the Emergency Liquidity Assistance (ELA) loaned to it by the Central Bank of Ireland. Writing off these debts would be considered an extreme form of the “monetary financing” that is prohibited under European Law by Article 123 of the European Treaty.

One might argue that the wheels of any European justice might grind slowly. However, Ireland is still reliant on loans from the ECB to its banks, from the EU to its government and would like ECB to use its OMT program to buy its bonds and perhaps arrange a precautionary credit line with the new bailout fund, the ESM. Against this background, the gains from unilaterally cancelling the promissory notes would probably be outweighed by the negative response from the rest of the Eurozone.

In relation to the idea that replacing one type of debt with another doesn’t make any difference, ask yourself this. Suppose you need to borrow €10,000 at a two percent annual interest rate. Which would you prefer: Paying it all off next year or paying it off over 50 years? The answer for most people is that paying it off slowly is preferable, particularly given the low interest rate. This is the argument for replacing the promissory notes with a very long-term bond.

Now here’s where things tend to get confusing. When thinking about the cost of this kind of arrangement, many people would focus on the interest rate on the bond the government is issuing (just as they focus now on the interest rate on the promissory notes). However, almost all of the interest paid from these bonds stays in Ireland. The interest goes from the exchequer to the IBRC and from the IBRC to the Central Bank of Ireland.

Consolidating everything, the only interest cost associated with the outstanding ELA debts stem from the fact that the Central Bank incurred a large Intra-Eurosystem liability via the TARGET2 system when the IBRC depositors and bond investors were paid off and moved their money abroad. Sourcing funds from abroad to pay off the ELA would have the effect of reducing this liability. However, the Central Bank only pays interest on this liability at the Main Refinancing Operation (MRO) rate, which is currently only 0.75%.

In contrast, the likely private market cost of very long-term funding for Ireland (if it was available at all) would probably be high, perhaps about 6 percent. It is for these reasons that extending out the repayment of IBRC’s debts to the Eurosystem for a long period is beneficial. In particular, providing the IBRC with a bond that could be used to source ECB funding at the MRO rate would mean 40 years of paying low interest rates on this debt.

Here is a spreadsheet that I have put together that illustrates why a long-term bond is preferable for Ireland to the current promissory note arrangements.

The assumptions underlying the spreadsheet are as follows:

The MRO is assumed to gradually increase to 3%.

The cost of ELA to IBRC is assumed to be 175 basis points higher than the MRO rate but this profit margin goes to the Central Bank and is subtracted off when calculating the net cost.

The Net Present Value of the two options considered here are calculated using a 6 percent discount rate. This is assumed to be the average post-crisis cost of long-term funds to Ireland that incorporates both a term and risk premium.

I have doubled next year’s promissory note payment to €6.2 billion to account for the fact that the Irish government has to pay back money it borrowed from Bank of Ireland to make last year’s payment.

An alternative to the promissory note arrangement is considered in which a 40-year bond is used as collateral for regular ECB loans which replace an equivalent amount the ELA debt. These ECB loans are rolled over for 40 years until the bond matures and the full amount is repaid.

The results show that the 40-year bond produces a reduction in the Net Present Value of the payments of 43% (an early version of this post had reported this as 37% but commenter Nene pointed out an error in the spreadsheet — thanks for the input Nene). Perhaps more important is the greatly reduced net financing needs over the next decade — €6 billion instead of €33 billion.

Is this enough to make Ireland’s debt sustainable? Perhaps not but it would be a definite improvement over the current arrangements.

Update: One point that I mentioned in response to a commenter below and that I should add because it’s important is that deferring the principal repayment until 40 years time gives plenty of room to decide to default on this obligation should that prove at any time to be the least-worst option available. As I wrote above, I don’t think this is the best option for Ireland now but a long-term bond leaves this options open to be pursued later. In the meantime, the annual cost of servicing this debt is pretty low.

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@Karl A lot of your article is misleading in the extreme – is it deliberate?

First of all we have: “Writing off these debts would be considered an extreme form of the “monetary financing” that is prohibited under European Law by Article 123″ ELA is not the same as monetary financing of Governments. Notwithstanding the fact that the Irish government guaranteed the debts of all Irish banks in 2008, by providing ELA to a Anglo, the ECB was doing its job as lender of last resort. It is not illegal for the ECB to provide unguaranteed liquidity assistance to a EZ financial institution and if that institution turns out to be insolvent, the original ELA does not suddenly become illegal.

“However, Ireland is still reliant on loans from the ECB to its banks, from the EU to its government and would like ECB to use its OMT program to buy its bonds and perhaps arrange a precautionary credit line with the new bailout fund, the ESM.” It is incredulous that you actually believe the above. The current Troika bailout is not in any way contingent on the continued payment of the promissory notes and is not in the MoU. And it is far more likely that we would not need the OMT or the ESM if we had a sustainable debt burden. But our debt burden is not sustainable because the promissory notes amount to about 20% of our GDP. Your logic here is in reverse. You say that we need can’t walk away from the Promissory Notes because we may need the OMT/ESM, but in fact it is more accurate to say we need may need the OMT/ESM because we have the Promissory Notes.

Regarding your assumptions: “The Net Present Value of the two options considered here are calculated using a 6 percent discount rate. This is assumed to be the average post-crisis cost of long-term funds to Ireland that incorporates both a term and risk premium. ” If an undergraduate made this assumption, I presume you would award him/her an F. Firstly, if the long-term post-crisis cost of funding will really be 6%, then Ireland would effectively be locked out of the debt markets and either have to default or rely on official funding of less than 4%. It is therefore incorrect to use 6%. In any case, it is specious to use the market yield of sovereign debt to discount this bond. By that logic, the larger and more unsustainable Ireland’s debt gets, the higher the yield would be, which would in turn would lower the NPV of the sovereign debt. This makes no sense at all and is just plain wrong. Ireland is the issuer of the debt and so from Ireland’s point of view the debt should be discounted at the risk free rate. Even if you do not agree with this, you should discount it at the same discount rate used for the promissory notes. It is misleading to value one solution with one discount rate and other solution with another, when the issuer is the same – a small adjustment could be made for the term, but the difference between the 10 year discount rate and the 40 year is close to negligable – it certainly would not reduce the NPV by 37%

The reality is that your solution would not reduce the NPV of the debt in any meaningful way and does not amount to any debt relief.

A long-term bond would in fact have the catastrophic effect of replacing very dodgy bank debt with bone fide sovereign debt. Perhaps you could tells what the seniority of this long term bond would be? Would it rank below sovereign debt holders? I doubt it. If it were pari passu or senior to existing market debt, then we would be sacrificing the interests of investors for the sake of pleasing our masters in Europe.

Furthermore, there is a non-negligable probability that the Euro will break-up, caused perhaps by a Grexit. In this case, the Prom Notes would be thrown in the bin. However, with your solution we would still €30bn to the EU.

Anyway, this whole argument is surreal. The government should just walk away from the Prom Notes – in this case, our debt would be under 100% of GDP and we would have a fighting chance of recovery. If the ECB retaliated by pulling the plug on the Irish banking system, then it would be the end of the Euro as no other Euro nation, least of all Spain and Italy, would tolerate the precedent that would be set. In short, that will not happen.

If we do not walk away from the PNs now we will end up defaulting on sovereign bond holders later. Of course, that is exactly the course the Government, armed with their apologists such as yourself, will embark upon.

Jeez, so much anger, so many misconceptions, it’s hard to know what to say Bazza.

A couple of points.

The calculation of NPVs uses the same discount rate for both sets of flows.

And as for “with your solution we would still €30bn to the EU” Tearing up the prom notes and walking off from any obligations would see CBI walking away from the TARGET2 liability associated with the funds the ELA financed getting out of the country. I don’t see why you think walking away from that is any different than walking away from the ELA. In any case, the calculations would be the same if this was a new 40-year ELA programme.

Anyway, I agree one of the advantages of the 40 year approach is that it facilitates walking away from the principal at some point if this turns out to be the best option.

I’m illustrating the potential gains from this restructuring. I explicitly say it may not be enough to restore debt sustainability. And if it’s not then something else has to be done. If that makes me an apologist so be it (and remember I’m also being hounded as a criminal default advocate on the site you hang out at). But it’s useful to have the facts first.

First of all, of course I’m angry. Aren’t you angry with the fact the state is assuming private banking liabilities to the tune of 20% of GDP?

As regards the discount rate, you know very well I mean to use the discount rate implied by the Promissory Notes (not 6%!). There is absolutely no way that your solution can meaningfully reduce the NPV of our national debt. You must know it is incorrect to value the sovereign debt with the market yield. By your rationale, the NPV of Irish debt would have declined during the first half of 2011, as our yield soared. That is rubbish.

Concerning the points in my last post that I made that you haven’t responded to, can I assume that you agree with them? If not, can you particularly deal with the seniority issue of your proposed solution?

The central issues here is that you want to exchange one exotic, junior instrument explicitly linked to a dead bank, with senior bone fide sovereign debt, with no significant write down of principal.

Frankly, I’m amazed and I’m starting to wonder if there is more to this. If we walked away from the PNs, wouldn’t that then show the world that Target2 liabilities are in fact risky? Hmmm….

While I totally disagree with the said accusations against you (is everyone on the IE site supposed to be of the same opinion now?) this article of yours does rile me. You know exactly how it goes: soon Noonan will be on the air claiming that a UCD economist says his new deal will reduce the cost of the PNs by 37%, when it will do nothing of the sort.

Bazza, I wouldn’t take a non-response from me as agreement. I’ve a lot on my plate and can’t reply to everyone that asks me questions.

On seniority, the sole purpose of the bond is for IBRC to use as collateral with either CBI or ECB — it’s just new longer promissory notes. If it’s decided that IBRC should default on its debts, the bond can be ripped up.

I don’t agree with your arguments about using the discount rate on the promissory notes — those rates are out-of-date irrelevant and the interest payments are largely circular. I didn’t invent the arguments about using the relevant marginal cost of funding to calculate NPVs and I’m guessing you can find them yourself out on the interenet. If you think 6% is a crazy long-term rate, then you haven’t factored in future increases in short-term rates and the risk premium that Ireland will carry for a long time.

As for Noonan claiming the 37% figure, I think he’d be correct to do so but I think he’ll stay well away from it because the question it begs is: What, only 37%?

We’ll see about the final deal, but at a wild guess any new money is going to be ranked as pari passu with existing official loans. In that case we would be sacrificing the interests of sovereign bond holders.

Regards you methodology about using the market rate – I think it is you who have made that up. The market rate should only be used for discounting if you are in the INVESTOR, not the borrower. If a company over-borrows, gets downgraded and the yields increase, the CFO doesn’t reduce the NPV of the company’s debt on the balance sheet. Similarily, when Ireland’s yields went to double digits last year, did the NPV of the gross government debt decrease as a result? Maybe in your world, but not on planet earth and not in EuroStat.

The interest rate of the Prom Notes is not irrelevant because it is the interest rate we are currently paying. From the debt issuers point of view, the only thing that matters is that interest rate. In your example, interest will continue to accrue over the 40 years so we do not gain anything.

While you’re thinking about that, you might also deal with your implicit claim that ELA provided to an institution that subsequently turns out to be insolvent is somehow a posteriori illegal monetary financing of Governments. With claims like that, maybe you should join IFO or Buba.

I know how the Notes work and I am referring not to the total interest we pay, but the effective interest rate, the MRO rate.

I apologise if I was “insulting” but you have been more than patronising in dealing with what I think is a real error in your assumptions, namely the use of a market interest rate to calculate the PV of the national debt.

You can look at it another way. An investor may be interested in the market NPV of a debt pile, but to the issuer of the debt, the only thing that is important is the book value. The book value does not depend on the current market yield.

Do you think Eurostat will adjust the value of the 40 year bond as market yield of Irish goverment debt fluctuates? How will the value of this bond be calculated when we have to implement the 1/20 rule in the Fiscal Stability Treaty?

To me, the big, big issue with replacing the PN with a 40 yr bond is that the bond would now be official government debt instead of being just a bank debt i.e. the Irish taxpayer would have to honour its repayment.

Currently the PN is not official government debt, therefore the Irish government could choose to not pay it.

BTY, what SPECIFICALLY, in your view, would be the “negative response” from the rest of the eurozone if Ireland choose not to pay the PN?

Hi Karl how’s trick,ah now are ya flogging a dead horse there,utilizing that photo,sur it’s the new headquarters for the Central Bank,needs a bit of work but… Your idea looks fab,but would there not be a bit of impact on the run off scenarios for IRBC,given that they are currently enjoying positive arbitrage.Last time I had a gander at their numbers,the spread was integral.Its been a while but what happens to IRBC under the above scary scenario,given the recent trade at 10 cents on the dollar of the plus 1bil Project Lane book by Llyods.

Arrgh. The 30 years is a typo. There had been a 30-year version before I made the 40-year version. Also, yes, 1/1.06 is better than 0.94 though it doesn’t make much difference. Changing both gives an NPV reduction of 43%. I’ve posted a new spreadsheet and changed the text.

Have neither the time nor the interest to explain it but take a quick look at the interm report,assuming your scheme and bad dream is clutched like a drowning man by the Irish govt. what happens next….. “Net interest income for the period totalled €538m, with €769m of interest income on the promissory notes being a key contributor.”

Michael Noonan’s Turkey Day description of what he was looking for was noticeably more cautious than previous versions

“We are working closely with the Troika and with our partners in Europe to break the vicious circle between banks and sovereigns. This commitment has been vital in allowing the State and the commercial sector to begin accessing international financial markets independent of each other. We are also working to find a new arrangement with the ECB to provide funding certainty to IBRC (what was Anglo Irish Bank).”

No more talk of debt reductions, ESM takeover of legacy debt … now it’s just “funding certainty to IBRC”

your article really goes to the heart of the problem and describes the seemingly advantages and pittfalls quite well. All in all, there are convincing arguments why such a transaction would count as monetary financing which is clearly not in line with the Eurosystem mandate. If the market rates are regarded to be too high and costly, then the Irish government should ask for ESM support.